HEG India — Graphite is the new Gold

When China sneezes the world catches a cold. Over the past few years, this quote
has mutated into indisputable truth. But very few people understand how China's
impact can be as far-reaching as it is. When the rush for Graphite electrode
(GE) began last year, the entire investor community started focusing on the
Indian twins- Graphite India Limited and HEG India, two GE producers whose
fortunes turned overnight. But it was, in fact, Chinese policy that ultimately
propelled the two companies to aim for the stars. So today we look at the story
behind the great rush for GE and how an Indian Company, HEG India can make or
break itself on the back of the Chinese dragon.

A Steely Beginning

We begin this story with steel and China's place in the equation. China has been
at the forefront of steel production for quite some time now and since most of
their factories are directly owned by the Chinese State, they almost always have
access to cheap credit (debt). This helped China boost their export count at the
expense of regional steel manufacturers elsewhere. When the world was being
overrun with cheap steel from China there was precious little other steelmakers
could do except urge lawmakers to hike import duty on Chinese steel (making it
more expensive) or simply sell their output at dirt cheap rates. This put steel
Manufacturers world over in a spot of trouble. However, there was another
interesting dynamic being played out elsewhere.

Steel Manufacturers in China largely relied on Blast Furnaces to produce their
steel. These old furnaces take in hot air and convert iron ore into steel under
extremely high temperatures and are considered to be prime polluters in Beijing.
In a world that was moving closer to environmentally friendly alternatives, this
was seen as problematic. Thankfully, the world had already begun switching to
more efficient steel producing techniques. One method, in particular, called the
Electric Arc Furnace (EAF) process was gaining significant traction. These
eco-friendly alternatives to Blast Furnace use Graphite electrodes to melt scrap
steel in electric arc furnaces to produce new steel. This development should
have put electrode graphite manufacturers on the map, unfortunately, the story
didn't quite play out as most people expected.

The Great Extinction

Graphite Electrode Manufacturers are a peculiar kind. There have been virtually
no new entrants in this space for the past 40 years and the incumbents have been
hobbling along without much fanfare. These electrodes are extremely hard to
manufacture and for the longest time hasn't been a lucrative endeavour. Also,
the main ingredient required to put together these electrodes, a high-value item
called needle coke (named because of its shape) was extremely hard to come by,
putting off any new developments in the space and then a period of severe
depression crippled the entire industry. Between 2015 and 2017 EAF steel
manufacturing facilities found it difficult to compete against the cheap steel
coming out of blast furnaces in China and when they cut down on production
graphite electrodes fell out of favour. Prices hit rock bottom and many
facilities across the world became unsustainable.

In 2017, China was the biggest producer and consumer of Graphite Electrodes,
followed by the European Union and Japan.

Back in India a humble manufacturer of Graphite Electrode was trying to turn the
tide. HEG India was already burdened with losses and significant debt as of FY
2017. Very few people saw the stock as a worthwhile investment opportunity until
the Chinese sneezed. News started pouring in that Beijing was on a drive to
close thousands of steel mills and other polluting plants including several
Graphite Electrode Manufacturers. On any other day, this news wouldn't have made
top headlines. However, this time things were slightly different. Steel supplies
had become dearer overnight.

In lieu of Blast Furnaces closing down across China, EAF Steel producers had to
step in to fill the void and the demand for Graphite Electrodes continued to
rally. Unfortunately, the terrible market scenario that prevailed in the
Graphite Electrode industry the previous year had wiped out ~20% of the total
manufacturing capacity making them a scarce product overnight as well. Some
began calling them strategic resources. The prices doubled, in some cases even
tripled. Companies that had already entered into long-term contracts could not
fully capitalise on the new found riches, but the ones that mostly sold on the
spot were in line for huge paydays and HEG India suddenly found itself in a very
sweet position.

Changing Fortunes

The stock price soared (from Rs. 300 to 3000+) and the earnings multiplied
prodigiously. From making losses to the tune of 47 crores (FY17) the company
turned a profit of over 1000 crores in FY18. They wiped off their long-term debt
and paid dividends of ~320 Crores. This year, the company has done even better.
It made profits of over 1600 crores in just 6 months and its planning to buy
back shares at a price of Rs. 5500 when the current market price is at ~Rs.
3900. The company doesn't know what to do with the money anymore. If there is
ever a story of changing fortunes HEG will be a serious contender to top that
list. However, the past is of little interest to investors. It's the future that
they crave for.

Based on data from the past two quarters, HEG has been selling its graphite
electrodes at an average price of about $15,000 per tonne. Its also running at
peak capacity, meaning they can't grow by selling more (Huge expansion sprees
are also out of the question because it's hard to source needle coke, the raw
material used to produce GE). So, by and large, the company can continue to
outperform if GE prices continue to soar, or if the collective public suddenly
realises that the stock is undervalued and they start bidding up the prices,
which is what a lot of research analysts believe ought to happen. So for the
stock price to continue its prodigious climb prices for Graphite Electrodes have
to rise in tandem. Surely that is something that we can predict right? Well......

Is it undervalued? The stock currently trades at a P/E of ~6 (Trailing Twelve
Months Earnings). Since the rally, the P/E has contracted prompting several
analysts to claim that the stock is in fact undervalued based on global
estimates. However, valuations are a tricky game and you'd be best advised to
exercise extreme caution while trying to unearth the "true" value of the stock

The Downside

On March 23rd, one of the world's largest producers of Graphite Electrode,
Graftech, filed its prospectus with the U.S. Securities and Exchange Commission
to go public. The IPO generated a lot of interest but it also prompted Indian
Investors to go have a peek. While outlining the risks involved in investing in
Graftech, the company noted — "Pricing for graphite electrodes has historically
been cyclical and, in the future, the price of graphite electrodes will likely
decline from recent record highs." This isn't the only cue that pointed towards
a decline. As of March 1, 2018, the company has already booked three- to
five-year contracts, representing ~ 60% to 65% of their production capacity from
2018 through 2022. The contracted price was $9,700 per tonne. So clearly, the
company did not expect the prices to stay well beyond $10,000 for a sustained
period.

Another hint comes from Nomura Research. In its endeavour to cover another large
GE Manufacturer, Showa Denko (Japanese Manufacturer), they visited China to find
out if the myth of Chinese Suppliers shutting down shop was in fact true. After
their visit, they had a very cautious story to tell. It seemed that the graphite
electrode manufacturers did take a hit but the ones that complied with
regulatory (environmental) standards were up and running already and looking to
add more capacity. Another seeming observation they made was that the country
was also ramping up its needle coke production — the scarce all important raw
material used to manufacture graphite electrodes. More Chinese Graphite
Electrodes would inevitably bring down prices. This prompted Nomura to revise
their earnings target for Showa Denko, on the premise that prices of Graphite
Electrode would peak at $8,500 per tonne and then moderate. This was back in
April 2018.

Outside of declining prices, HEG has another worry. Prices of Needle coke has
been on the rise and this hasn't affected the margins until now mainly because
it takes a while for the company to order the material and then use them in
production. However, starting this quarter we are likely to see some pressure on
input prices. It is entirely possible that the company decides to pass on this
extra cost to its buyers or it could take some of this burden itself. But
despite what it chooses to do, it seems that the golden period is about to end,
Or is it?

The Upside

The upside is that since these predictions were made, prices of Graphite
Electrodes have in fact rallied further. As we have already noted Indian
Manufacturers continue to sell Graphite Electrodes at prices close to $15,000
per tonne. So what seemed unlikely back in April no longer seems unlikely
anymore. It's not just the analysts that are stumped. It seems the companies
themselves are stumped as well. Tokai Carbon, another company that manufactures
Graphite Electrode had to revise its earning estimates upwards this November, in
lieu of recent developments. The only explanation on hand is that the
supply-demand mismatch continues to persist and China still isn't ready to
bridge the gap. Considering Chinese manufacturers are increasingly looking to
adapt to EAF based production methods most of China's Graphite Electrode
production will perhaps go into meeting this new burgeoning demand. And if China
remains a net importer (Imports more GE than it exports) the price is likely to
stay up for the foreseeable future.

Another assessment is that Chinese Graphite Electrodes are less efficient(HP
Grade) as opposed to the widely used UHP graded electrodes. So the belief is
that, even if Chinese production does catch up, UHP electrodes will continue to
rule the roster. However, investors must bear in mind that steel manufacturers
will use UHP so long as it makes economic sense and if prices continue to remain
sky high it's likely they will switch to the lower grades HP electrodes.

The China Factor

Since the story began to unfold last year, multiple investors have been looking
at it as a cyclical play, characterised by ebbs and flows. However, despite the
inherent cyclicality in the business (it continues to follow the steel industry
which is cyclical) the structural shift in pricing is likely to stay that way
for some time. The only thing that could disrupt this structure is the Chinese
juggernaut. And unfortunately, very few people seem to know what the Chinese are
up to. Even the Chinese authorities themselves have little clue about the
country's GE Manufacturing capacity. So any bet that you take will also
ultimately depend on your knowledge of China's capacity. For now, it seems like
the demand-supply equation is tightly in balance. But if China walks in to play
spoilsport all of this could change very quickly. Not overnight. But quick
enough nonetheless.

So Fellow reader, Where is your bet?

Disclaimer: No content on this website should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. The author accepts no liability for any actual investments based on this article.